William J. Rainer
Commodity Futures Trading Commission
Testimony Before the Senate Agriculture Committee
Hearing on the Report by the President's Working Group on Financial Markets: "Over the Counter Derivatives Markets and the Commodity Exchange Act"
February 10, 2000
Thank you Chairman Lugar, Senator Harkin and members of the Committee. I appreciate the opportunity to come here and discuss the recommendations of the President's Working Group on Financial Markets regarding the Commodity Exchange Act and over-the-counter derivatives transactions.
U.S. financial markets generally are the envy of the world, whether we are speaking of futures, swaps or securities. Each of these sectors plays an important role in maintaining America's leadership in this area.
Our country's position in the OTC market is affected by uncertainty over the legal status of many derivatives transactions. This uncertainty turns on whether or not transactions could be invalidated under the CEA.
The members of the Working Group are unanimous in our assessment of America's national economic priorities for the over-the-counter derivatives markets. These goals have already been mentioned, namely:
· to promote technological innovation, competition, efficiency, liquidity and transparency; and
· to reduce systemic risk by encouraging the market to develop regulated clearing systems.
The ability to achieve these will be enhanced through greater legal certainty for the OTC market. Congressional action to exclude OTC financial derivatives from the Act would provide such certainty.
I can advocate this step because OTC derivatives transactions as we know them today do not present regulatory concerns within the scope of the Act. Also, excluding this activity will not diminish the CFTC's ability to carry out the statutory mission it is charged to fulfill.
* * *
When the Commodity Exchange Act was written, Congress articulated the rationale for regulating futures transactions. First, the Act establishes the economic utility of futures trading, stating that futures prices "are generally quoted and disseminated throughout the United States and in foreign countries as a basis for determining prices to the producer and the consumer of commodities ...." In addition to their price discovery function, futures transactions are used by commercial handlers "as a means of hedging themselves against possible loss through fluctuations in price." CEA Section 3.
The second prong of Congress' rationale for regulation is that the "transactions and prices of commodities ... are susceptible to excessive speculation and can be manipulated, controlled, cornered or squeezed ...." The risks of price distortion and manipulation are the factors "rendering regulation [of these markets] imperative ...." CEA Section 3. Congress thus identified the overarching public mission of the CFTC as that of preventing price manipulation and ensuring price transparency.
* * *
Like exchange-traded futures, OTC derivatives are risk-shifting instruments. The Working Group, however, has determined that, unlike futures, "prices established in OTC derivatives transactions do not serve a significant price discovery role." PWG Report at 16. The Working Group also has concluded that "[m]ost OTC derivatives are not susceptible to manipulation." Id.
According to the Bank for International Settlements, 72 percent of OTC derivatives are interest rate contracts and 26 percent are foreign exchange contracts.1 A report issued recently by the Office of the Comptroller of the Currency stated that interest rate contracts constitute 79 percent of derivatives held in US commercial banks. Interest rate and currency products, which together comprise 98 percent of the OTC derivatives market, do not present the concerns Congress addressed in mandating the regulation of futures.
Moreover, OTC transactions are entered into and traded by sophisticated institutional traders, who are able to look out for themselves in these markets. Also, most dealers in the swaps market are either affiliated with broker-dealers or futures commission merchants that are regulated by the SEC or the CFTC, or are financial institutions that are subject to supervision by bank regulatory agencies. Therefore, the activities of most derivatives dealers already are subject to direct or indirect federal oversight. PWG Report at 16.
Because there is no manifest regulatory interest warranting CFTC oversight of OTC derivatives, I support the exclusion proposed by the Working Group.
Congress and the CFTC have acted before to resolve legal uncertainty affecting OTC derivatives. In 1992, amid strong signals that swap market participants feared their contracts could be declared unenforceable, Congress responded decisively, instructing the CFTC not to regulate swaps entered into by sophisticated parties. Congress authorized the CFTC to provide exemptive relief for swaps without requiring the agency to make a threshold determination that particular exempted transactions fell within its jurisdiction.2 The CFTC promptly issued a rule exempting swap agreements from all provisions of the Act except prohibitions against fraud and manipulation, provided the swaps meet certain conditions.
The CFTC's swaps exemption worked relatively well. Lately, however, evolution in the OTC derivatives market has rendered the exemption inadequate for some purposes.
The swaps exemptive rule does not apply to OTC contracts that are standardized, cleared, or executed under conditions that approximate those of an organized exchange. Technology, however, is dramatically changing the structure and nature of many aspects of the financial services industry. The rise of electronic, screen-based trading has blurred the line drawn in our swaps exemption between bilateral and multilateral trading. The growth in swap volume, and the acceptance of these contracts by a wider range of users, has led to their standardization. Public policy must meet these advances in the OTC market.
I also believe that the development of regulated clearing systems should be encouraged. Clearing systems can employ a variety of risk management tools, such as mutualizing risk and offsetting multiple obligations. Consequently, clearing systems help reduce systemic risk by lowering the possibility that the failure of a single market participant could disproportionately disrupt or impact the overall market.
Finally, the Commission's rule exempts bilateral swaps from all provisions of the CEA except those provisions prohibiting manipulation and fraud. The CFTC thought it prudent to retain its jurisdiction to act in the event the agency learned that participants were engaging in fraudulent or manipulative conduct and that transactions executed under the exemption were, in fact, futures.
The swaps exemption does not alter the CFTC's responsibility to take action against this misconduct. In a given set of circumstances, however, the agency's ability to act may be contingent upon proving that transactions are futures or options.3 This is a critical point to remember: at no time has Congress or the CFTC made the definitive judgment that swap transactions are, in fact, subject to the CEA's jurisdiction. The combination of responsibility with no more than contingent authority, is simply bad public policy because as a practical matter, the CFTC cannot exercise its residual enforcement authority under the swaps exemption without exacerbating the existing legal uncertainty in this area.
* * *
Apart from legal certainty issues regarding OTC derivatives, the Working Group report contains recommendations aimed at improving the regulatory framework for other financial instruments. Some of these proposals have been addressed by other members of the Group. I would like to comment on the recommendation to alter the "Treasury Amendment" provision of the Act to give the CFTC explicit jurisdiction over unregulated entities that sell foreign exchange instruments to the public at large.
Abusive promoters have exploited regulatory gaps to sell foreign currency contracts to financially unsophisticated individuals, making exaggerated claims of profit opportunities and failing to disclose the risks of these inherently volatile instruments. Promoters often target senior citizens, recent arrivals in this country and other vulnerable segments of society.
Many of these enterprises simply pocket investor funds; others channel funds to currency markets, but typically do so without adequate segregation or disclosure. As fraudulent forex companies proliferated, the agency in 1998 issued a consumer advisory through the mass media warning the public about these schemes. Cases filed by the CFTC against illegal foreign currency operations during the 1990s have involved more than $250 million in customer funds.
Courts in which the CFTC has brought enforcement actions have reached varying decisions regarding our jurisdiction over these instruments. In those jurisdictions where we have not been foreclosed judicially from enforcement action, we continue to move aggressively against retail forex fraud. We also cooperate with state, local and other federal authorities to bring a halt to this activity.
We ask Congress to clarify our authority to regulate these instruments so that we may provide a stronger deterrent to fraud and abuse while providing a zone of comfort and rational oversight to legitimate enterprises that want to offer foreign currency contracts to the public.
* * *
While examining the applicability of the Act to OTC markets, we also have conducted an inquiry into whether our current regulatory scheme is appropriately tailored to today's environment for exchange-traded futures. During the past several months, the agency has undertaken a serious effort to answer the question: what degree of exchange-traded regulation is necessary to serve the public interests entrusted to us?
This inquiry is at the heart of the process that the CFTC has engaged in over the last several months. A strong consensus exists among ourselves, Congress and the Working Group that such a review is needed.
Impending technological changes require the CFTC to scrutinize the continued vitality and viability of its one-size-fits-all regulatory structure that currently applies to all futures transactions. While that process is not yet complete, certain clear principles have emerged: one, the historic needs of traditional physical commodities should not be the basis for regulating every futures contract traded today; two, institutional market participants do not require all of the protections designed for retail traders.
Although I will not get into much detail here, let me say that at its core, this plan will afford market participants the opportunity to operate in a regulatory environment suited to the product traded and the participants trading it. The key policy elements of this plan include a move from direct to more oversight regulation; a move from prescriptive rules to flexible performance standards; and the increased use of disclosure-based regulation.
This plan will not impair the agency's ability to assure the fundamental market integrity that is expected when conducting futures exchange transactions in the United States, or when relying upon the prices set in US exchange-traded markets. The Commission will continue to exercise its authority to oversee their continued integrity.
* * *
In conclusion, Mr. Chairman, time is not our ally in establishing a framework that achieves our national economic priorities with respect to derivatives trading. Technology has made it increasingly easy to establish rival markets in foreign jurisdictions; technology has also increased the speed with which new innovations are introduced and widely used by market participants. Because of these realities, I ask Congress to act expeditiously on the recommendations of the Working Group.
Thank you again for the opportunity to testify before you today. I look forward to continued collaboration with the rest of the Group and the members of this Committee to see these recommendations enacted into law this year.
1 Bank for International Settlements, Press Release, The Global OTC Derivatives Market at End-December 1998 (June 2, 1999).
2 See Conf. Rept. 102-978, Futures Trading Practices Act of 1992, at 81-82 (Oct. 10, 1992).
3 The CEA authorizes the Commission to take enforcement action against "any person" suspected of attempting to manipulate "the market price of any commodity in interstate commerce," irrespective of whether the suspected misconduct occurs in the cash commodities markets or on-exchange. CEA Section 6(c).